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26 Chapter 25

Economic Growth

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Growth
Why do the Economic growth is
economies of some measured as a
countries grow from percentage increase in
year to year, while real GDP (or real GDP
others move ups and per capita) over time.
downs, and others
suffer of stagnant

Economic growth is
This Chapter examines the an important
causes of economic growth,
as well as the costs and
economic goal
benefits of because it improves
growth. standards of living.
Economic Growth

Economic growth is
illustrated by an
outward shift of the
possibilities curve.

Economic growth is measured as an increase in

Real GDP.
To check if people are better off, divide the Real GDP by population.
This is called Real GDP per Capita.
To have a real growth per capita (or in other words
effective increase in Real GDP Per Capita) : % in real
GDP must be % in population
Nominal vs. Real GDP Growth Of China 1994 - 2011
Growth as a Goal
Economic Growth refers to an increase in the
productive capacity of an economy as a result of
which the economy is capable of producing
additional quantities of goods and services.
Our standard of living is measured by the quantity of
goods and services available to us so that economic
growth is synonymous with an increase in the
general standard of living.
To preserve or increase our standard of living we
need to achieve an economic growth equals or
higher than the population growth.
Arithmetic of Growth

Rule of 70
In order to find the number of years required to
double a countrys GDP, you need to divide 70 by
the annual percentage rate of growth. The result
is the approximate number of years that it will
take for this country to double its GDP.

Approximate 70
number of years = annual percentage rate
required to double
real GDP of growth
Economic Growth

Rule of 70
Number of years
required to
double real GDP
= annual percentage rate
of growth

Number of years 70
required to
double real GDP
= 3.5
= 20
Economic Growth

Growth in U.S. real GDP 1950-2009

Increased 6 fold
3.2% per year
Growth in U.S. real GDP per capita
Increased more than 3 fold
2% per year
Improved products and services
Added leisure
Other impacts

LO1 25-13
Modern Economic Growth
Growth-promoting institutional
Strong property rights
Patents and copyrights
Efficient financial institutions
Literacy and education
Free trade
Competitive market system

LO3 25-14
Sources of Economic Growth
Supply factors Demand factor
Increases in quantity Households,
and quality of natural businesses, and
resources government must
Increases in quality purchase the economys
and quantity of human expanding output
Increases in the supply Efficiency factor
(or stock) of capital Must achieve economic
goods efficiency and full
Improvements in employment
Key Terms

LO3 25-19
26 Chapter 26
Business Cycles, Unemployment, and

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Business Cycle

The long-run trend of economic growth is usually

interrupted by periods of economic instability
caused by business cycles.
Business cycles are ups and downs in the level
of economic activity, sometime over several
Each cycle (one up followed by one down)
vary substantially in duration and strength.
The Business Cycle
Next figure shows the four phases of a business cycle:
At a peak, business activity reaches a temporary maximum. Here the
economy is near full employment and the level of real output is at or very
close to the economys capacity, and the price level is likely to rise.
A recession is a period of decline in total output, income, and
employment. This downturn, which lasts 6 months or more, is marked by
shrinkage of business activity in many sectors of the economy. Along with
declines in real GDP, significant increases in unemployment occur.
In the trough of the recession or depression, output and employment
bottom out at their lowest levels. The trough phase may be either short-
lived or quite long.
A recession is usually followed by an expansion, a period in which real
GDP, income, and employment rise. At some point, the economy again
approaches full employment. If spending expands more rapidly than does
production, prices of nearly all goods and services will rise. In other words,
inflation occurs.
Phases of the Business Cycle

Level of Real Output




Cyclical Impact:
Durables and Nondurables
Cyclical Impact: Durables and Nondurables
Although the business cycle is felt everywhere in the economy, it
affects different segments in different ways and to different degrees.
Firms and industries producing capital goods (for example, housing,
commercial buildings, heavy equipment, and farm implements) and
consumer durables (for example, automobiles, personal computers, and
refrigerators) are affected most by the business cycle. Buyers can
postpone the purchase of capital goods and durable goods. As a result, in
vestment in capital and durable goods declines.
In contrast, service industries and industries that produce nondurable
consumer goods are somewhat protected from the most severe effects of
recession. People find it difficult to cut back on needed medical and legal
services, for example. And a recession actually helps some service firms,
such as law firms that specialize in bankruptcies. Nor are the purchases of
many nondurable goods such as food and clothing easy to postpone. The
quantity and quality of purchases of nondurables will decline, but not
so much as will purchases of capital goods and consumer durables.

Twin problems of the business cycle

Measurement of unemployment
Whos in the labor force? Answer: (16 +)
Problems with the unemployment rate
Part-time employment (Listed as Full Time)
Discouraged workers (BLS drop them out of labor
Unemployment Rate = x 100
Labor Force
U.S. Unemployment 2009

Under 16
(71.4 Million)

Not in
Labor Force
(81.7 Million)
(307.3 Million)

Employed Labor
(139.9 Million) Force
(154.2 Million)
Unemployment 14.3
Rate = x 100
= 9.3% Unemployed
(14.3 Million)
Class Practice

Calculate the Unemployment Rate in Fiji where

there is a population of 1 million. 550,000 out of
labor force and 38,250 are unemployed.
Types of Unemployment
Frictional Unemployment
Unemployment due to people being in the process of moving
from one job to another.
At any given time some workers are between jobs. Some of them will
be moving voluntarily from one job to another. Others will have been
fired and will be seeking reemployment.
Still others will have been laid off temporarily because of seasonal
demand. In addition to those between jobs, many young workers will
be searching for their first jobs. Frictional unemployment is inevitable
and, at least in part, desirable. Many workers who are voluntarily
between jobs are moving from low-paying, low-productivity jobs to
higher-paying, higher-productivity positions.
Types of Unemployment
Structural Unemployment
Unemployment due to economic or technological change,
rather than fluctuations in supply or demand.
Changes over time in consumer demand and in technology change
the structure of the total demand for labor, both occupationally and
geographically. Occupationally, the demand for certain skills may
decline or even disappear. The demand for other skills will intensify.
Unemployment results because the composition of the labor force
does not respond immediately or completely to the new structure of
job opportunities. Workers who find that their skills and experience
have become obsolete or unneeded thus find that they have no
marketable talents. They are structurally unemployed until they adapt
or develop skills that employers want. Geographically, the demand for
labor also changes over time. An example: the migration of industry.
Types of Unemployment

Cyclical Unemployment
Unemployment due to the cyclical trends in growth (business
cycle). At Recession, cyclical unemployment will be high.
Unemployment that is caused by a decline in total spending is called
cyclical unemployment and typically begins in the recession phase
of the business cycle. As the demand for goods and services
decreases, employment falls and unemployment rises. Cyclical
unemployment results from insufficient demand for goods and
Type of Unemployment

Full employment defined:

Full employment is the level of employment rates
when there is no cyclical or short-demand
unemployment. It is defined by economists as being
an acceptable level of unemployment somewhere
above 0%.
Natural rate of unemployment:
The lowest rate of unemployment that an economy
can bear over the long run. (Some suggests 4 5 %).
Cost of Unemployment

Economic Costs of Unemployment

Foregone output
Potential output
GDP gap = actual output potential output
Okuns Law
Each 1% above NRU creates negative 2% output gap
Noneconomic Costs of Unemployment
Some cyclical unemployment is a social catastrophe.

Continuous Rise in general level of prices

Consumer price index (CPI)
Market basket
300 goods and services
Typical urban consumer
2 year updates
Price of the Most Recent Market
Basket in the Particular Year
CPI = Price estimate of the Market
x 100
Basket in the base year
Measurement of Inflation
The main measure of inflation is the Consumer Price Index (CPI)
The CPI index is used to report inflation rates each month and each
year. The CPI is also used to adjust Social Security benefits and
income tax.
In the U.S., the CPI reports the price of a market basket of some
300 consumer goods and services that are purchased by a typical
urban consumer.
The GDP price index of Chapter 24 is a much broader measure of
inflation since it includes not only consumer goods and services but
also capital goods, goods and services purchased by government,
and goods and services that enter world trade.
The market basket for the CPI is updated every 2 years so that it
reflects the most recent patterns of consumer purchases and
captures the inflation that consumers are currently experiencing. The
CPI is set equal to 100 for a base year.
Types of Inflation
Demand pull Inflation:
Excess spending relative to output
Central bank issues too much money
Effects on Output:
One view is that zero inflation is best
Another view is that mild inflation is best
Cost-push Inflation:
Due to a rise in per-unit input costs
Supply shocks
Effects on Output:
Reduces real output
Redistributes a decreased level of real income
Types of Inflation
Demand pull Inflation:
Usually, increases in the price level are caused by an
excess of total spending beyond the economys capacity
to produce. Where inflation is rapid and sustained, the
cause invariably is an over issuance of money by the
central bank.
When resources are already fully employed, the business
sector cannot respond to excess demand by expanding
output. So the excess demand bids up the prices of the
limited output, producing demand pull inflation.
The essence of this type of inflation is too much spending
chasing too few goods.
Types of Inflation
Cost-push Inflation:
Inflation may also arise on the supply side of the economy.
Rising costs of factors of production raise per-unit costs.
A per-unit cost of production is the average cost of a
certain level of output. This average cost is found by
dividing the total cost of all resource inputs by the amount
of output produced, i.e. per-unit production cost = total
input costs / units of output.
Rising per-unit production costs squeeze profits and
reduce the amount of output firms are willing to supply. As
a result, the economys supply of goods and services
declines and the price level rises.
In this scenario, costs are pushing the price level upward,
whereas in demand-pull inflation demand is pulling it
Redistribution Effects of Inflation
Nominal income
Unadjusted for inflation
Real income
Nominal income adjusted for inflation
Anticipated vs. unanticipated income
Percentage change
in real income = Percentage change
in nominal income
Percentage change in
price level

LO3 26-43
Who is hurt by inflation?

Fixed-income receivers

Who is unaffected or unhurt by inflation?

Flexible-income receivers
Social Security recipients
Union members
Pay back the loan with cheaper dollars
Who Is Hurt by Inflation?
Unanticipated inflation hurts fixed-income recipients, savers, and creditors. It
redistributes real income away from them and toward others.
Fixed-Income Receivers
People whose incomes are fixed see their real incomes fall when inflation occurs.
Retirees who receive fixed pension, landlords who receive fixed lease payments.
Likewise, government employees.
Minimum-wage workers and families living on fixed welfare incomes also will be
hurt by inflation.
Unanticipated inflation hurts savers. As prices rise, the real value, or purchasing
power, of an accumulation of savings deteriorates. Paper assets such as savings
accounts, insurance policies, and annuities decline in real value during inflation.
Unanticipated inflation harms creditors (lenders). Suppose Chase Bank lends Bob
$1000, to be repaid in 2 years. If in that time the price level doubles, the $1000
that Bob repays will have only half the purchasing power of the $1000 he
As prices go up, the value of the dollar goes down. So the borrower pays back less
valuable dollars than those received from the lender. The owners of Chase Bank
suffer a loss of real income.

LO3 26-45
Who is unaffected or unhurt by inflation?
Some people are unaffected by inflation and others are actually helped by it
Flexible-Income Receivers
People who have flexible incomes may escape inflations harm or even benefit from
it. For example, individuals who derive their incomes solely from Social Security are
largely unaffected by inflation because Social Security payments are indexed to the
CPI. Benefits automatically increase when the CPI increases, preventing erosion of
benefits from inflation.
Some union workers also get automatic cost-of-living adjustments (COLAs) in their
pay when the CPI rises, although such increases rarely equal the full percentage
rise in inflation.
Some flexible-income receivers and all borrowers are helped by unanticipated
inflation. The strong product demand and labor shortages implied by rapid
demand-pull inflation may cause some nominal incomes to spurt ahead of the
price level, thereby enhancing real incomes.
Unanticipated inflation benefits debtors (borrowers). In our earlier example, Chase
Banks loss of real income from inflation is Bobs gain of real income. Debtor Bob
borrows dear dollars but, because of inflation, pays back the principal and
interest with cheap dollars whose purchasing power has been eroded by
inflation. Real income is redistributed away from the owners of Chase Bank
toward borrowers such as Bob.

LO3 26-46
Anticipated Inflation

Nominal Interest Rate

Real Interest Rate
Inflation Premium

= 5% + 6%

Nominal Real Inflation

Interest Interest Premium
Rate Rate
Anticipated Inflation
If inflation is anticipated, the redistribution of income from lender to
borrower may be altered. Suppose a lender (say a commercial bank)
and a borrower (a household) both agree that 5 percent is a fair rate of
interest on a 1-year loan provided the price level is stable. But assume
that inflation has been occurring and is expected to be 6 percent over
the next year.
If the bank lends the household $100 at 5 percent interest, the bank
will be paid back $105 at the end of the year. But if 6 percent inflation
does occur during that year, the purchasing power of the $105 will have
been reduced to about $99. The lender will, in effect, have paid the
borrower $1 for the use of the lenders money for a year.
The lender can avoid this by charging an inflation premiumthat is,
by raising the interest rate by 6 percent, the amount of the anticipated
By charging 11 percent, the lender will receive back $111 at the end
of the year. Adjusted for the 6 percent inflation, that amount will have
roughly the purchasing power of $105 worth of todays money.

LO3 26-48
Key Terms
business cycle Okuns law
peak inflation
recession Consumer Price Index (CPI)
trough demand-pull inflation
expansion cost-push inflation
labor force per-unit production costs
unemployment rate nominal income
discouraged workers real income
frictional unemployment anticipated inflation
structural unemployment unanticipated inflation
cyclical unemployment cost-of-living adjustments
full-employment rate of (COLAs)
unemployment real interest rate
natural rate of unemployment nominal interest rate
(NRU) deflation
potential output hyperinflation
GDP gap